Thursday, November 8, 2018

Operating an Unregistered Digital Tokens Exchange is Unlawful

It didn't come as a surprise that the SEC today published an order announcing a settlement of charges it brought against Zachary Coburn, the founder of EtherDelta, a digital token trading platform.

The SEC has in the recent past brought charges against token issuers for failing to register their token offerings or comply with an available exemption, as well as against platforms for failing to register as broker dealers.  I previously wrote about them here and here.  Today's SEC order is long overdue but is much needed.  It sends a clear signal to the crypto industry that it is not outside of the existing regulations and that all crypto industry participants will be regulated to the extent required by the existing laws.  The crypto exchanges should register just like the traditional exchanges or operate pursuant to an available exemption.

Beginning in July 2016, EtherDelta provided a platform for trading Ether and various digital tokens (about 50), as well as a smart contract that ran on the Ethereum blockchain that was coded to validate the order messages, confirm trade order terms and conditions, execute orders, and update the distributed ledger to reflect the trade.  The website resembled an online securities trading platform.  Users could enter orders to buy or sell specified quantities of any token at a specified price.

The platform continued its operations even after the SEC's DAO Report that was issued on July 25, 2017, where the SEC advised that a platform that provides secondary trading in digital tokens that are securities is required to register with the SEC as a national securities exchange (or be exempt from such regulations).

Although Zachary Coburn posted on Reddit that "his platform function[ed] just like a normal exchange]", it was "decentralized ... Centralized exchanges won't be able to show you verified business logic [in a publicly verified smart contract]".  The decentralized nature of the exchange is not a new argument.  Many of our prospective clients (which never became real clients) claimed that their contemplated crypto exchanges did not need to register due to their decentralized nature. 

Section 5 of the Securities Act prohibits any exchange from effecting any transaction in a security unless registered with the SEC as a national securities exchange or operates pursuant to an exemption.  An "exchange" is defined in Section 3(a)(1) of the Exchange Act (and also the Exchange Act Rule 3b-16(a)) that say that an exchange is "any organization, association, or group of persons, whether incorporated or unincorporated, which .... provides a market place or facilities for bringing together purchasers and sellers of securities...".  One of the exemptions is for alternative trading systems (ATSs) that comply with Regulation ATS (they must, among other things, be registered as broker-dealers, file Form ATS with the SEC, and establish written safeguards and procedures for protecting users' confidential trading information).

The SEC found that "EtherDelta operated as a market place for bringing together the orders of multiple buyers and sellers in tokens that included securities" without registration or exemption, regardless of its decentralized nature.  The SEC also found Coburn to be an active and integral part of EtherDelta who exercised complete control over its operations.

I assume that EtherDelta was never registered as a legal entity.  However, its digital decentralized nature did not prevent the SEC from charging Coburn, the man behind the platform, for operating an unregistered exchange.       

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Sunday, October 21, 2018

Investment Funds Primer - Crypto Funds Overview

I was motivated to write this series of blog posts after attending the NYU Stern FinTech Conference, where I led lunchtime discussion about crypto funds and investing.  In this blog post, I aim to summarize what I see as the state of development of this recently new but quickly growing investment class.   In the next blog post, I will try to explain the regulatory vacuum that allows (and explains) some of this proliferation.

First, let's talk about the statistics so we can understand the magnitude of what is happening.  It is estimated that currently there are 621 crypto funds around the world (a half of them being in the United States), 198 of which were launched in 2017 and a projected 220 in 2018.  Roughly half of the crypto funds (303 out of 621) are small: they have less than $10 million AUM and less than 5 employees.  188 crypto funds have AUM between $10 million and $50 million, and only 37 funds have AUM of over $100 million (such as Pantera Capital, Galaxy Digital Assets, Alphabit Fund, and Polychain Capital).  So, to summarize, 621 crypto funds manage over $7.1 billion, and it is all done by less than 5,000 people globally (most of whom are located in the U.S.).

Now, let's talk about the crypto fund strategies.  Crypto funds are private investment vehicles that raise money to invest into various types of crypto or digital assets.  The main categories are crypto hedge funds and crypto venture capital funds.  Crypto hedge funds act more like typical hedge funds: some actively trade cryptocurrencies on various exchanges, others adopt a buy and hold approach, some are passive index funds that invest in indices of top performing cryptocurrencies, yet others invest into crypto funds of funds, some are AI-driven quant funds that use machine learning to execute statistical arbitrage strategies, and some are token basket funds that invest into baskets of crypto assets.   Crypto venture capital funds invest into ICOs, tokens, and equity of blockchain-related startups.

At this point I would like to briefly summarize the U.S. laws that apply to investment funds generally.  There are no specific regulations yet that apply only to crypto funds. 

The Securities Act of 1933 regulates the process of how the funds can raise investment capital.  Onshore fund offerings are typically conducted in reliance on Regulation D under the Securities Act.  Funds are also subject to the anti-fraud and insider trading regulations under the Securities Act and the Securities and Exchange Act of 1934.  Their disclosures to investors may not contain false or incomplete information.

The Investment Company Act of 1940 (the "Company Act") regulates trading activities of entities that "engage primarily, in the business of investing, reinvesting, or trading in securities" and are "investment companies."  Most traditional hedge funds rely on exemption from the definition of "investment company" found either in Section 3(c)(1) or 3(c)(7) of the Act.  This means that funds either cannot have more than 100 investors or all of investors have to be "qualified purchasers" - a much higher standard of wealth than what is required to be an accredited investor.

The Investment Advisers Act of 1940 (the "Advisers Act") regulates the fund managers that are in the "business of advising others . . . as to the value of securities or as to the advisability of investing, purchasing, or selling securities" and after the Dodd-Frank Act, generally requires them to register with either state agencies or with the SEC.

The Commodities Exchange Act (the "CEA") regulates commodity swaps and other commodity derivatives and investment advisers that advise commodity pools.

As I will explain in the next blog post, some crypto funds escape from most of the current regulations because they do not invest into, or advise on, securities.  The question of what is a "security" becomes paramount.  Investing in  commodities can place the crypto funds outside of regulation of the Company Act, the Advisers Act, and the CEA, thus significantly lowering barriers to crypto fund formation and management.  This helps explain the growth phenomenon of the crypto funds.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Tuesday, October 9, 2018

Investment Funds Primer: Different Hedge Fund Structures. Part I of Many

As our investment fund practice expands, we have decided to post a series of blogs relating to the basics of hedge fund and private equity fund structuring issues and considerations.

What is a hedge fund?

Hedge funds are often unfairly confused with hedging. “Hedging” is the practice of attempting to reduce risk (similar to getting an insurance), but the goal of most hedge funds is to maximize return on investment. Hedge funds are also often confused with private equity funds. Hedge funds generally invest in publicly traded securities and derivative instruments. Their portfolios can be marked to market. Investors can at any time invest into the funds as well as redeem their interests (subject to limitations, of course). Some hedge funds do invest a portion of their assets in illiquid securities though “side pockets,” but those are less common. Private equity funds, on the other hand, invest in securities of private companies, and therefore are much less liquid. They place significant restrictions on the investors’ ability to invest (only during the subscription period) and exit the fund (mostly only at the expiration of the fund’s term that can be as long as ten years).

Hedge fund structures

Single domestic fund. A stand-along domestic fund is typically a Delaware limited partnership or a Delaware limited liability company. The investors become its members, and the investment managers acts as the fund’s manager or general partner. If the fund is set up as an LLC, the manager receives limited liability protection as a manager of the company, whereas if the fund is set up as an LP, it does not. Therefore, to limit personal liability of the investment manager, it is important to establish a separate investment management entity as an LLC.

In cases where the investment manager will manage only one fund, the investment manager may also act as a general partner of the LP / manager of the LLC. Alternatively, the investment manager may act through its own entity advising various funds. In such case, it becomes necessary for the fund to enter into an investment management contract with the investment manager, in addition to having it or another entity be the general partner / manager of the fund.

Fund of funds. These structures have recently become very popular. Funds of funds are investment vehicles that, instead of investing into securities or other assets, invest into other hedge funds, private equity funds, or other type of funds. Some funds invest across a broad spectrum of assets, including hedge funds, private equity funds, venture capital funds, and real estate funds. Funds of funds provide for maximum diversification of investment and therefore spearing of the risk, as each “portfolio” fund itself invests in multiple assets or securities. It is also easier to invest into funds of funds, as the investment manager can rely on the due diligence done by the managers of the portfolio funds. Further, investing into funds of funds allows investors access to those funds that have high minimum investment amount, thus excluding smaller investors. Note that investing into funds of funds may be more expensive, since the fund of funds’ management fee is layered on top of the management fees of each portfolio fund. It is of course possible for the funds of funds to make direct investments into the underlying funds’ securities in addition to the underlying funds themselves.

Parallel funds. Parallel funds typically involve an onshore fund and an offshore fund that invest directly into the underlying portfolio of assets. The onshore fund has a general partner that itself is a pass-through entity for U.S. federal income tax purposes. The onshore fund pays management fees to the management company and makes an incentive allocation to the general partner. The offshore fund will also pay management fees to the management company, but will also pay an incentive fee to it. Such management company is typically an affiliate of the general partner. Recent tax changes (2008) disallowed the management company to defer the time of the receipt of the incentive fee from the offshore fund, and therefore some offshore funds have created mini-master funds descried below.

The parallel fund structure allows funds to invest differently in the underlying portfolio due to tax or regulatory considerations, although the objective is for the underlying portfolios to be identical.

Master-feeder funds. In a master-feeder structure, each of the onshore and the offshore feeder funds hold an interest in an entity that is treated as a partnership for U.S. federal income tax purposes, the master fund. The master fund invests into the underlying portfolio of assets. Investors in the onshore and the offshore feeders participate in exactly the same investments, and have the same compensation arrangements for the fund managers. In some master-feeder funds, the master fund makes an incentive allocation to its general partner or managing member and pays the management fee to the management company. It is also possible that each of the feeder funds pays a management fee to the management company, and the onshore feeder makes an incentive allocation to its general partner, whereas the offshore fund pays an incentive fee to a management company that is an affiliate of the general partner of the onshore fund.  However, as we mentioned above, this structure is no longer common.

Frequency of redemption requests at the feeder fund level must correspond to the frequency allowed by the master fund, since the money is invested by the master fund and the feeder would need to redeem some of its interest in the master fund in order to meet the redemption request at the feeder fund level.

Typically, the master fund would have a limited number of partners: only the general partner, the onshore feeder, and the offshore feeder.

Parallel funds with mini-master. In this structure, the onshore fund has the same structure as in the parallel funds structure described above. The offshore fund structure, however, has changes. Since it will be treated as a corporation for U.S. federal income tax purposes, it cannot make incentive allocations. So instead it pays an incentive fee to the management company. Due to the elimination of deferral fee arrangements in 2008, some investment managers have modified this by adding a mini-master structure.

In the mini-master structure, the offshore fund is the sole limited partner in a partnership (mini-master) and the general partner of the mini-master is the same as the general partner of the onshore fund or its affiliate. This allows the offshore fund to make incentive allocation to its general partner.

Of course, these are the most basic structures, and in real life, they are much more complicated.  But we thought we would start our fund blog series with the basics.

In the next blog post, we will describe the types of investors that invest into such funds, and the legal considerations involved in dealing with different types of investors. In the later blog posts, we will describe how to set up funds (again, from the legal perspective), and what laws and regulations apply to the funds and the fund managers.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Arina Shulga or Kristina Subbotina.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.